'ARMs' Against a Sea of Troubles

"Whether 'tis nobler in the mind to suffer the slings and arrows of outrageous
fortune, or to take arms against a sea of troubles, and by opposing end
them?" - Hamlet, William Shakespeare

Hamlet - a tragedy of inaction. How appropriate. In this second line of this
play's most memorable monologue, which begins, "To be or not to be," we see
Hamlet questioning whether or not to take action. Should he suffer in solitude
from the hidden truth that he is privy to, or should he confront the situation,
deal with the consequences, and bring true resolution to Denmark, his country?

Perhaps, Greenspan and other government officials thought it nobler that our
country should take no radical action and suffer the slings and arrows of outrageous
fortune. Yet what we need is what we've needed all along. We need the resolve
to take the necessary actions to set our economy on a sustainable path. That
was always going to be difficult; now, it looks as though it will be
so even more.

If I started at the beginning, I'd end up with a novel the size of War
and Peace, which neither of us would read. So, I'll start somewhere in
the middle, though I'm quite sure where we'll end.

After coming off the final remnant of the gold standard in 1971, with the
whole world now on fiat currencies, we were free to inflate. And so, we did.
Our reasons were, and are, complex, some good, and some bad. But that is another
article for another day. We began inflating and we began our journey to becoming
the world's greatest debtor nation.

Thus began the great bull market in credit. From 1982 to 2000, the Dow went
from 875 to 11,722, our trade deficit expanded from $24 billion to $378 billion1,
our nation's total non-financial debt growth rate went from $439 billion to
$836 billion, and the household mortgage borrowing rate increased from $47.6
billion to $368 billion.23

As the boom turned to bust in 2000, Greenspan, a good Keynesian ("the remedy
for the boom is not a higher rate of interest, but a lower one"), stepped in
and cut rates from 6.5 percent in 2001 to 1 percent in 2003, flooding the economy
with credit. As well, the Greenspan Fed flooded the money supply. From 2000
to 2005, the money supply has grown from $6.6 trillion to $9.8 trillion, the
trade deficit has doubled from $378 billion to an annualized $685 billion4,
the total non-financial debt growth rate has tripled from $836 billion to $2.4
trillion, and the household mortgage borrowing rate has more than doubled from
$368 billion to $801 billion.56

My point in all this is to show the reader that we are nearing an endpoint.
If we extrapolate theses numbers, we see an accelerating rate of the growth
that is evidence of the fact that our economy is on an unsustainable, parabolic
trajectory. We have "printed" more and more money in increasingly shorter timeframes
and have engaged in exceedingly riskier investment transactions to try to keep
the party going just a little longer. Even in the last five years, we've traded
the consequences of a popping stock bubble for multiple bubbles that now look
ready to pop.

As you try to find a point of reference to assign meaning to these numbers,
consider them against the backdrop of what will be one of our largest problems
- the housing and real estate mania.

Naturally, these lower interest rates caused most of us to desire to buy a
house or buy a bigger one. The law of supply and demand combined with an increasing
supply of dollars and produced rising house prices. Most of us thought something
like, "If the prices of houses are rising and interest rates are so low, we'd
be foolish not to buy now so we can lock in a low rate and start growing our
equity."

On January 3, 2004, Greenspan noted, "In the aftermath of the bursting of
the [stock market] bubble, by June 2003 the federal funds rate was lowered
to its current 1 percent, the lowest level in 45 years. There appears to be
enough evidence, at least tentatively, to conclude that our strategy of addressing
the bubble's consequences rather than the bubble itself has been successful.
Highly aggressive monetary ease was doubtless a significant contributor to
stability."7

Against an economic topography of job losses followed by abysmal job and wage
growth (again, another topic for another day), rather than selling their houses
and/or lowering their standards of living, many Americans applied for home
equity loans. Banks, burgeoning with cash from the above-mentioned monetary
stimulus, were happy to oblige. Indeed, from 2000 to 2005, home equity loans
more than doubled from a rate of $90 billion to $221 billion.8 So,
lending standards were relaxed, and we saw the growth of no-money-down loans
and "re-financing" offered with no employment documentation, unheard of in
prior years. Risk continued to increase.

Soon, the cost of housing priced itself beyond the ability for the average
wage earner to afford a purchase. So, we emphasized Adjustable Rate Mortgages
(ARMs), with lower initial rates, so those who wanted to, could buy. After
all, rates were coming down and "homeowners might have saved tens of thousands
of dollars had they held adjustable-rate mortgages rather than fixed-rate mortgages
during the past decade," said Greenspan on February 23, 2004.9

It is odd that he should say that then. Greenspan is often oblique and always
measured and specific in his words, exercising caution for their effects. Yet
Greenspan made this statement after he had lowered rates to 1 percent
in June 2003, and just a short while before he began raising interest rates, " at
a pace that is likely to be measured," in June 2004.10 No caveat.
No further explanation of where we were in the rate cycle. Just a clumsy, blanket
statement.

Oh, well. I guess we all make mistakes.

Interestingly, as measured by a Fannie Mae report on the contents of purchase
loans backing mortgage-backed securities, ARMs have grown from 18 percent to
72 percent from 2001 to 2005.11 Of course with ARMs, if interest
rates climb, the borrowers must pay an upward adjusted rate, increasing their
aggregate mortgage payments, and correspondingly straining their cash flows
further. Risk continued to increase.

In speaking to those who had "become increasingly concerned about the exceptional
run-up in home prices", in October 2004 Greenspan noted that "Housing price
bubbles presuppose an ability of market participants to trade properties as
they speculate about the future. But upon sale of a house, homeowners must
move and live elsewhere. This necessity, as well as large transaction costs,
are significant impediments to speculative trading and an important restraint
on the development of price bubbles."12 His line of reasoning seems
to be that we can't have a housing bubble because, since we live in our houses,
we can't trade houses like stocks.

Not the most tenable argument, but okay, we'll let it pass. Besides, this
was before the debut of condoflip.com.

Housing prices continued to rise. However, more and more houses were being
bought as investments. Consider that " 23 percent of all homes purchased in
2004 were for investment, while another 13 percent were vacation homes. In
addition, there was a record of 2.82 million second home sales in 2004, up
16.3 percent from 2.42 million 2003."13

The main problems with houses as investments, is that one has to pay the mortgage
until the prices rises enough to sell it for a profit. Rents cratered, as everyone
wanted to, and could, buy a home. Interest-only ARMs allowed for an even smaller
payment. Now, someone with very little cash flow could purchase a home and
meet the monthly mortgage requirements. Interest-only ARMs grew from 3 percent
to 50.9 percent from 2001 to 2005.14 Risk continued to increase.

Then in November 2004, well into his interest rate tightening cycle, Greenspan
said in response to a question, "rising interest rates have been advertised
for so long and in so many places that anyone who has not appropriately hedged
this position by now is obviously desirous of losing money."15

Homebuyers who took out ARMs shortly before or after Greenspan's clumsy comment
just eight months earlier would likely disagree. They might even feel a bit
insulted or somehow cheated. Surely, Greenspan didn't mean any harm, yet from
the rate of growth in ARM financing, it looks as though harm was done.

Against a backdrop of increasingly manic credit creation, it didn't matter
if you didn't have a job and flipped houses and condos for a living. If I only
had a dollar bill for all the faxes I received advertising, 1 percent ARMs
with the following enticements. Any credit, any income, no document loans.
Bankruptcy and foreclosure are okay. Get cash out, pay off bills, and skip
two payments - credit approval regardless of credit history. Risk expanded
all the more. No wonder sub prime interest-only ARMs increased from
0 percent to 23.5 percent in from 2001 to 2005.16 Risk continued
to increase.

Now, in August 2005, Greenspan observes that "America's economic imbalances, most
notably the large current account deficit and the housing boom," could
end in "more-wrenching changes in output, incomes, and employment." He then
goes on to say that, "The rising prices of stocks, bonds and,
more recently, of homes, have engendered a large increase in
the market value of claims which, when converted to cash, are a source
of purchasing power." Greenspan then warns, "Such an increase in market
value is too often viewed by market participants as structural and permanent.
But what they perceive as newly abundant liquidity can readily disappear."17

Greenspan has recently spoken of an interest rate conundrum. I have a conundrum
of my own. How is it that our Fed Chairman makes a passing comment that people
could have saved ten's of thousands of dollars if they had used ARMs and later
downplays the possibility of a housing bubble. He then goes on to remark that
interest rates increases have been forecasts for so long that anyone who has
not prepared for them is basically stupid and to warn of a housing bubble that
could sap all the equity from homeowners and leave them heavily indebted.

Is this negligence or something worse?

And for those who took out adjustable rate mortgages (ARMs), they had best
hope that interest rates remain low. According to Deutsche Bank's analysis,
by 2007 "$1 trillion of the nation's mortgage debt - or about 12 percent
of it - [will be] switching to adjustable payments."18

So, how will this end?

It doesn't really matter what I think. Instead, I'd rather offer excerpts
from Chapter II of the International Monetary Fund (IMF) report titled, "When
Bubbles Burst," which offers a historical perspective on "macroeconomic and
financial after-effects of the bursting of asset price bubbles."

I continued to shake my head as I read:

"The most virulent [busts] were those that occurred in conjunction with the
breakdown of [monetary] pegged exchange rates and oil shock[s].

The price corrections during housing busts averaged 30 percent.

Housing price crashes lasted about 4 years [and] the association between booms
and busts, with an implied probability of 40 percent, was stronger for housing
than for equity prices.

They generally coincided or overlapped with recessions.

Housing price busts across countries suggests that they were often synchronized.

Financial deregulation, which triggered or facilitated many of the housing
price booms, ended in a bust.

This is the sea of troubles against which we must take action. At this point
we see that we will be hit by the storm. It is unavoidable. If our country
and our leaders will not take appropriate action, how should we prepare? As
I wrote at the beginning, this is going to be difficult. Each day the cost
of inaction grows greater.

As for Greenspan, in 1966 he wrote, "The excess credit which the Fed pumped
into the economy spilled over into the stock market - triggering a fantastic
speculative boom. Belatedly, Federal Reserve officials attempted to sop up
the excess reserves and finally succeeded in breaking the boom. But it was
too late: by 1929 the speculative imbalances had become so overwhelming that
the attempt precipitated a sharp retrenching and a consequent demoralizing
of business confidence. As a result, the American economy collapsed."20

How expedient is has become for Greenspan to wander so far from his own words.

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